The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Cineplex Inc (TSE:CGX) delivered a less impressive 8.94% ROE over the past year, compared to the 15.31% return generated by its industry. Though CGX’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on CGX’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CGX’s returns.
What you must know about ROE
Return on Equity (ROE) is a measure of Cineplex’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Cineplex, which is 8.47%. While Cineplex’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Cineplex which is encouraging. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Cineplex can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Cineplex currently has. At 84.08%, Cineplex’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Although Cineplex’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Cineplex, there are three pertinent factors you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Cineplex worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Cineplex is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cineplex? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.